Pension Lump Sum or Annuity? How to Decide

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The answer to the question, “Should I take a lump sum or an annuity from my pension?” might be: “Yes.”

Sometimes it’s best to take the lump sum and use it to buy your own annuity, which is a stream of monthly payments that typically lasts for your life and often the life of your spouse. Other times, you would be fine accepting the annuity your employer provides. Investing the lump sum on your own often is the riskiest option and may not be a good fit for many retirees.

Traditional pensions, also known as defined-benefit plans, promise workers a certain amount in retirement (or a “defined benefit”). They’ve become less common in the private sector as companies switched to 401(k) and other defined contribution plans, where no benefit is guaranteed in retirement. Defined benefit pensions are seen as expensive and riskier for employers since they’re on the hook to provide monthly pension checks for the rest of their employees’ lives.

To cut costs and transfer risk to retirees, companies sometimes offer lump sums instead of monthly checks. Lump sums can provide retirees the freedom to invest or spend as they choose, but that also can mean losing the money to bad markets or bad choices.

The best option for you depends on the answers to two critical questions:

1. How healthy is the entity providing the annuity?

Some pension funds are critically underfunded. That’s especially true of many multi-employer plans that are supposed to provide pensions to union members.

Your pension plan is required to provide you annual updates on its financial well-being. You can also check the plan’s Form 5500 form, which discloses its financial condition, at FreeErisa.com. The vital information is in Part III of Schedule B or MB, which will list the plan’s current assets, current liabilities and percentage of funding. Ideally, that last number will be close to or over 100%.

The Pension Benefit Guaranty Corporation can step in and take over failed single- or multi-employer plans, but people may not get everything they’re owed. In a single-employer plan, the maximum annual benefit the PBGC pays to a 65-year-old is $67,295. In a multi-employer plan, payouts are limited to $35.75 per month times years of service. For a 30-year employee, that’s just $12,870 annually.

If you’re afraid [a plan is] not going to have enough money 20, 30 years from now and you won’t get your pension or you’ll get a vastly reduced pension, that can be a real reason to take that money now.

Christine Russell, TD Ameritrade

“If you’re afraid they’re not going to have enough money 20, 30 years from now and you won’t get your pension or you’ll get a vastly reduced pension, that can be a real reason to take that money now,” says Christine Russell, senior manager of retirement and annuities at TD Ameritrade.

Another reason for taking a lump sum over an annuity is if the annuity options don’t fit your circumstances, Russell says. For example, you may want your spouse to continue getting 100% of your monthly check after you die, but the available options are limited to 50% or 75%. Or you may want to take a portion of your pension in cash for an emergency fund and “annuitize” the rest. If your pension doesn’t offer that option, you can take the lump sum, keep some in cash and use the remainder to buy an immediate fixed annuity from an insurance company that can send you monthly checks for life.

If you decide to purchase your own annuity, you’ll want to make sure the insurer is financially sound and able to honor its promises to pay. Look for “A” ratings from rating companies such as A. M. Best, Moody’s, Standard & Poor’s, and Fitch. State guaranty associations will step in if an insurer goes bankrupt and cover annuities up to certain limits (generally $250,000), but you’ll want to avoid the hassles and delays of dealing with an insurer’s insolvency.

Also, some private companies opt to purchase annuities from an insurance company instead of making the payments directly. These insurers are generally reputable, Russell says, but you should check out the company’s ratings before accepting the annuity option.

2. Will I have enough guaranteed income to cover basic expenses in retirement?

The longer a person lives, the greater the chance of running out of money, and many people underestimate the longevity risk that they and their spouses face. A 65-year-old man will live to 84 on average and a 65-year-old woman to 86.5, while a married couple at 65 has a 50% chance one spouse will live to 92.

“I can say, ‘Well, I think I’m going to live to 85,’ but what if I live until 95? You really don’t know,” Russell says.

Women are at particular risk of outliving their money, since they live longer and often have less saved for retirement. Those who are married at the start of retirement usually outlive husbands — often by many years, and sometimes by decades. When spouses die, household income can plunge as one of the couple’s two Social Security checks goes away.

Men are still doing the majority of this planning for retirement, but they are often ignoring what’s going to happen to their spouse after they die.

“Men are still doing the majority of this planning for retirement, but they are often ignoring what’s going to happen to their spouse after they die,” Russell says. “Having this lifetime pension payment can be absolutely critical to not going into poverty later on in life.”

A good way to manage longevity risk is to make sure you have enough guaranteed income from Social Security, pensions and annuities to cover your basic expenses, says Lewis Mandell, a financial literacy expert and author of “What to Do When I Get Stupid: A Radically Safe Approach to a Difficult Financial Era.”

Having enough guaranteed income means your basic standard of living isn’t dependent on how well your investments perform, Mandell says. Also, our financial decision-making ability tends to decline with age, which can leave us more vulnerable to financial abuse, fraud and bad investment decisions that could wipe out our nest eggs. Guaranteed income can keep the lights on and the fridge full regardless of what happens to our other assets, he says.

People trying to decide between a lump sum or an annuity often focus on whether they could earn more by investing the lump sum, Russell says. But at retirement, people should switch from the “accumulator” mindset of maximizing their returns to one more focused on mitigating risk.

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